Farm balance-sheet-analysis2765

Farm Balance Sheet AnalysisFarm Balance Sheet Analysis
AAE 320AAE 320
Paul D. MitchellPaul D. Mitchell

GoalGoal
 Overview accounting balance sheet as itOverview accounting balance sheet as it
pertains to agricultural operationspertains to agricultural operations
 How to prepare and/or read oneHow to prepare and/or read one
 How to use one (financial ratios)How to use one (financial ratios)

Balance SheetBalance Sheet
 Systematic listing of everything owned andSystematic listing of everything owned and
owed by a business/individualowed by a business/individual
 Gives statement of owner equity at a pointGives statement of owner equity at a point
in timein time
 Typically for end of accounting period,Typically for end of accounting period,
such as end of year for taxessuch as end of year for taxes
 Interim balance sheets often used/neededInterim balance sheets often used/needed
for loan applicationsfor loan applications

Balance SheetBalance Sheet
 Balance sheet: Everything must balanceBalance sheet: Everything must balance
 Asset: anything ownedAsset: anything owned
 Liability: debt or financial obligation owedLiability: debt or financial obligation owed
 The Basic Accounting Identity must holdThe Basic Accounting Identity must hold
Assets = Liabilities + Owner EquityAssets = Liabilities + Owner Equity
Owner Equity = Assets – LiabilitiesOwner Equity = Assets – Liabilities
 Equity is what’s left, the residualEquity is what’s left, the residual

Uses of Balance SheetUses of Balance Sheet
 Measures financial position of firm,Measures financial position of firm,
focusing on long and short run measuresfocusing on long and short run measures
 SolvencySolvency: measures relative relationships: measures relative relationships
among assets, liabilities and equity toamong assets, liabilities and equity to
assess “health” of firm (financial ratios)assess “health” of firm (financial ratios)
 LiquidityLiquidity: measures ability to meet current: measures ability to meet current
financial obligations as they come duefinancial obligations as they come due
without disrupting normal business—abilitywithout disrupting normal business—ability
to generate cash on short-termto generate cash on short-term

Balance Sheet FormatBalance Sheet Format
AssetsAssets LiabilitiesLiabilities
Current AssetsCurrent Assets $100$100 Current LiabilitiesCurrent Liabilities $50$50
Non-CurrentNon-Current
AssetsAssets
$150$150 Non-Current LiabilitiesNon-Current Liabilities $100$100
Owner EquityOwner Equity $100$100
Total AssetsTotal Assets $250$250 Total Liability and EquityTotal Liability and Equity $250$250

AssetsAssets
 Anything the firm owns that has valueAnything the firm owns that has value
because can sell it and/or use it tobecause can sell it and/or use it to
produce sellable goodsproduce sellable goods
 Liquid assets: easy to sell, ready marketLiquid assets: easy to sell, ready market
for them (grain, feeder livestock)for them (grain, feeder livestock)
 Illiquid assets: hard to sell quickly at fullIlliquid assets: hard to sell quickly at full
value (machinery, land, breedingvalue (machinery, land, breeding
livestock)livestock)

Assets on Balance SheetAssets on Balance Sheet
 Current AssetsCurrent Assets
 Cash, bank accounts, marketable funds,Cash, bank accounts, marketable funds,
accounts receivable (money owed to you),accounts receivable (money owed to you),
inventories of liquid assets: grain, feed,inventories of liquid assets: grain, feed,
supplies, feeder livestocksupplies, feeder livestock
 Non-Current AssetsNon-Current Assets
 Everything else: machinery, equipment,Everything else: machinery, equipment,
breeding livestock, buildings, landbreeding livestock, buildings, land

Liabilities on Balance SheetLiabilities on Balance Sheet
 Obligations or debts owed; any outside claimsObligations or debts owed; any outside claims
against one or more of your assetsagainst one or more of your assets
 Current LiabilitiesCurrent Liabilities
 Financial obligations due within 1 yearFinancial obligations due within 1 year
 Accounts at suppliers, farm store, etc.Accounts at suppliers, farm store, etc.
 Interest & principle on operating and long-term loansInterest & principle on operating and long-term loans
 Accrued expenses: property and income taxesAccrued expenses: property and income taxes
 Non-Current LiabilitiesNon-Current Liabilities
 Everything else not due in the next yearEverything else not due in the next year
 Remaining balance on long-term debtsRemaining balance on long-term debts afterafter
deducting the current year’s paymentsdeducting the current year’s payments

Alternative Balance Sheet FormatsAlternative Balance Sheet Formats
 Traditional farm balance sheets usedTraditional farm balance sheets used
other categories, but use decreasingother categories, but use decreasing
 Intermediate Asset: less liquid with life 1 toIntermediate Asset: less liquid with life 1 to
10 years (machinery, equipment,10 years (machinery, equipment,
perennial crops, breeding livestock)perennial crops, breeding livestock)
 Fixed Asset: > 10 year life: land, buildingsFixed Asset: > 10 year life: land, buildings
 Intermediate Liability: 1 – 10 year loansIntermediate Liability: 1 – 10 year loans
 Long-term Liabilities: > 10 year loansLong-term Liabilities: > 10 year loans

Owner Equity = Net WorthOwner Equity = Net Worth
 Value left after assets are used to cover allValue left after assets are used to cover all
liabilities, what you “own” in the farmliabilities, what you “own” in the farm
 Your current investment in the farmYour current investment in the farm
 Equity changes for many reasonsEquity changes for many reasons
 Profits/losses from production activitiesProfits/losses from production activities
 Sell assets for different values than on sheetSell assets for different values than on sheet
 Add/withdraw capital from the farmAdd/withdraw capital from the farm
 Asset value changes if use market prices forAsset value changes if use market prices for
asset valuation, e.g., land value increasesasset valuation, e.g., land value increases

Owner Equity = Net WorthOwner Equity = Net Worth
 Business transactions only change the mix ofBusiness transactions only change the mix of
assets/liabilities, not owner equityassets/liabilities, not owner equity
 Buying a $10,000 piece of machinery does notBuying a $10,000 piece of machinery does not
change your equitychange your equity
 If cash purchase, current assets drop $10,000 andIf cash purchase, current assets drop $10,000 and
non-current assets increase $10,000non-current assets increase $10,000
 If borrow $10,000, liability increases $10,000 andIf borrow $10,000, liability increases $10,000 and
non-current assets increase $10,000non-current assets increase $10,000
 Equity only changes due to business profit/loss,Equity only changes due to business profit/loss,
if you put money in/pull it out, and/or (in someif you put money in/pull it out, and/or (in some
cases) if asset values changecases) if asset values change

Asset Valuation ProblemAsset Valuation Problem
 How do you value assets whenHow do you value assets when
developing a balance sheet, Cost ordeveloping a balance sheet, Cost or
Market BasisMarket Basis
 Basic accounting says use cost basis, butBasic accounting says use cost basis, but
not always right in agriculturenot always right in agriculture
 Cost Basis: value = purchase cost minusCost Basis: value = purchase cost minus
depreciation, or = farm production costdepreciation, or = farm production cost
 Market Basis: value = current marketMarket Basis: value = current market
value minus selling costsvalue minus selling costs

Market BasisMarket Basis
 Assets valued at current market value minusAssets valued at current market value minus
selling costsselling costs
 Asset value (and so your equity) responds toAsset value (and so your equity) responds to
inflation and price changes, so often givesinflation and price changes, so often gives
higher values (and so higher equity)higher values (and so higher equity)
 Asset price changes can hide managementAsset price changes can hide management
problems because equity increasingproblems because equity increasing
 Main Advantage: more accurate measure ofMain Advantage: more accurate measure of
current financial health and collateral availablecurrent financial health and collateral available
for loans, so often used by lendersfor loans, so often used by lenders
 Lenders’ needs influence farm balance sheetsLenders’ needs influence farm balance sheets

Cost BasisCost Basis
 Asset value = purchase cost minusAsset value = purchase cost minus
depreciation, or cost to produce the assetdepreciation, or cost to produce the asset
 More conservative, following acceptedMore conservative, following accepted
accounting practices in other businessesaccounting practices in other businesses
 Equity changes only from retainedEquity changes only from retained
earnings, not from asset price changesearnings, not from asset price changes
 Can misrepresent true value of businessCan misrepresent true value of business

Farm Financial StandardFarm Financial Standard
CommitteeCommittee
Recommends using both methodsRecommends using both methods
1) Market basis balance sheet with cost basis1) Market basis balance sheet with cost basis
asset values in attached schedules or inasset values in attached schedules or in
footnotesfootnotes
2) Double Column balance sheet for assets,2) Double Column balance sheet for assets,
with market basis and cost basiswith market basis and cost basis
Measure true value market of your businessMeasure true value market of your business
and identify possible management problemsand identify possible management problems

Both Methods use BothBoth Methods use Both
MethodsMethodsAssetAsset Cost BasisCost Basis Market BasisMarket Basis
Raised grain andRaised grain and
feeder livestockfeeder livestock
MarketMarket MarketMarket
Purchased grain andPurchased grain and
feeder livestockfeeder livestock
Min of Cost andMin of Cost and
MarketMarket
MarketMarket
Accounts ReceivableAccounts Receivable CostCost CostCost
Prepaid ExpensesPrepaid Expenses CostCost CostCost
Investment in cropsInvestment in crops
growing in the fieldgrowing in the field
CostCost CostCost
Purchased breedingPurchased breeding
livestocklivestock
CostCost MarketMarket
Raised breedingRaised breeding
livestocklivestock
Cost or Base ValueCost or Base Value MarketMarket
Machinery, equipment,Machinery, equipment,
buildings, landbuildings, land
CostCost MarketMarket

Grain/Livestock Inventories andGrain/Livestock Inventories and
Crops in the FieldsCrops in the Fields
 Grain in the bin, animals on the lot readyGrain in the bin, animals on the lot ready
to go, use market basisto go, use market basis
 Exception: Purchased grain/livestock that hasException: Purchased grain/livestock that has
gone up in value, use cost if on a cost basisgone up in value, use cost if on a cost basis
 Crops still growing in the field, use cost,Crops still growing in the field, use cost,
since still subject to production riskssince still subject to production risks
 ““Don’t count your chickens before the eggs hatch”Don’t count your chickens before the eggs hatch”

Raised Breeding LivestockRaised Breeding Livestock
 Cost basis: supposed to accumulate allCost basis: supposed to accumulate all
costs to get the animal from birth tocosts to get the animal from birth to
productive age (and not include these inproductive age (and not include these in
the income statement), then depreciatethe income statement), then depreciate
this total cost over its useful lifetime just asthis total cost over its useful lifetime just as
though purchased it at this pricethough purchased it at this price
 Alternative: a fixed base value for eachAlternative: a fixed base value for each
age/type of animal to approximate thisage/type of animal to approximate this
cost and its depreciation, won’t changecost and its depreciation, won’t change
with asset market priceswith asset market prices

DepreciationDepreciation
 Annual loss in value of a working asset due toAnnual loss in value of a working asset due to
use, wear, aging, and technical obsolescenceuse, wear, aging, and technical obsolescence
 What assets due you depreciate?What assets due you depreciate?
 Useful life > 1 yearUseful life > 1 year
 Useful life can be determined (not unlimited)Useful life can be determined (not unlimited)
 Machinery, equipment, buildings, fences,Machinery, equipment, buildings, fences,
breeding livestock, perennial crops, irrigationbreeding livestock, perennial crops, irrigation
wells, land improvements (wells, drainage)wells, land improvements (wells, drainage)
 Land not depreciated, as has unlimited lifeLand not depreciated, as has unlimited life

Depreciation DefinitionsDepreciation Definitions
 CostCost: All costs paid for the asset, including: All costs paid for the asset, including
price, taxes, delivery and installation fees,price, taxes, delivery and installation fees,
expenses to get the asset into useexpenses to get the asset into use
 Useful LifeUseful Life: Number of years you expect to: Number of years you expect to
use the asset in your businessuse the asset in your business
 Salvage ValueSalvage Value: Expected market value at: Expected market value at
end of useful you assigned; zero if you willend of useful you assigned; zero if you will
use it until worn out and has no scrap oruse it until worn out and has no scrap or
junk value at endjunk value at end

Depreciation IntuitionDepreciation Intuition
 Want to allocate the initial cost of long termWant to allocate the initial cost of long term
asset across the useful life you give itasset across the useful life you give it
 Cost – Salvage Value is asset’s totalCost – Salvage Value is asset’s total
depreciation over its Useful Life—Howdepreciation over its Useful Life—How
much do you assign to each year?much do you assign to each year?
 Several formulas makeSeveral formulas make assumptionsassumptions andand
estimateestimate annual depreciation, none isannual depreciation, none is
correct for all assets in all situationscorrect for all assets in all situations

Graphics of DepreciationGraphics of Depreciation
Time (Years)Time (Years)
Value($)Value($)
Initial CostInitial Cost
SalvageSalvage
ValueValue
Useful LifeUseful Life
TotalTotal
to Allocateto Allocate

Graphics of DepreciationGraphics of Depreciation
Time (Years)Time (Years)
Value($)Value($)
BB
AA
Use a mathematical formula to describe howUse a mathematical formula to describe how
to get from Point A to Point Bto get from Point A to Point B
Slope of the line between any two years is theSlope of the line between any two years is the
annual depreciation during that yearannual depreciation during that year
Depreciation =Depreciation = ∆∆Value/Value/∆∆tt
One YearOne Year
∆∆t = 1t = 1
∆∆VV

Straight Line DepreciationStraight Line Depreciation
 Draws a straight line between beginning andDraws a straight line between beginning and
ending values, constant depreciation each yearending values, constant depreciation each year
 Annual DepreciationAnnual Depreciation
= (Cost – Salvage Value)/Useful Life= (Cost – Salvage Value)/Useful Life
 Alternative: Express as a depreciation rateAlternative: Express as a depreciation rate
 Annual DepreciationAnnual Depreciation
= (Cost – Salvage Value) x R= (Cost – Salvage Value) x RSLSL
RRSLSL = 1/Useful Life = Depreciation Rate= 1/Useful Life = Depreciation Rate
Example: RExample: RSLSL = 1/10 = 0.10 = 10%= 1/10 = 0.10 = 10%
10% annual depreciation rate10% annual depreciation rate

Straight Line Depreciation ExampleStraight Line Depreciation Example
 $100,000 machine, use for 6 years and$100,000 machine, use for 6 years and
expected salvage value of $40,000expected salvage value of $40,000
 Annual Depreciation =Annual Depreciation =
($100,000 – $40,000)/6 = $10,000($100,000 – $40,000)/6 = $10,000
 RRSLSL = 1/6 = 0.167 = 16.7%= 1/6 = 0.167 = 16.7%
($100,000 – $40,000) x 16.7% = $10,020($100,000 – $40,000) x 16.7% = $10,020

Straight Line Depreciation ExampleStraight Line Depreciation Example
Value AtValue At
Year StartYear Start
Value AtValue At
Year EndYear End
YearYear Beginning BasisBeginning Basis DepreciationDepreciation Ending BasisEnding Basis
11 100,000100,000 10,00010,000 90,00090,000
22 90,00090,000 10,00010,000 80,00080,000
33 80,00080,000 10,00010,000 70,00070,000
44 70,00070,000 10,00010,000 60,00060,000
55 60,00060,000 10,00010,000 50,00050,000
66 50,00050,000 10,00010,000 40,00040,000

0
20,000
40,000
60,000
80,000
100,000
120,000
0 1 2 3 4 5 6
Year
ValueatYearStart

Sum of the Year’s DigitsSum of the Year’s Digits
Annual Depreciation =Annual Depreciation =
(Cost – Salvage Value) x RUL/SOYD(Cost – Salvage Value) x RUL/SOYD
RUL = Remaining Useful Life atRUL = Remaining Useful Life at STARTSTART of yearof year
SOYD = sum of the year’s digits from 1 to Useful LifeSOYD = sum of the year’s digits from 1 to Useful Life
Example: Useful Life = 6 years, thenExample: Useful Life = 6 years, then
SOYD = 1 + 2 + 3 + 4 + 5 + 6 = 21SOYD = 1 + 2 + 3 + 4 + 5 + 6 = 21
SOYD = n(n +1)/2, where n = Useful LifeSOYD = n(n +1)/2, where n = Useful Life
Largest depreciation in first year, constant decreaseLargest depreciation in first year, constant decrease
in depreciation for each year after thatin depreciation for each year after that

Sum of the Year’s DigitsSum of the Year’s Digits
Depreciation ExampleDepreciation Example
 SOYD’s = 1 + 2 + 3 + 4 + 5 + 6 = 21SOYD’s = 1 + 2 + 3 + 4 + 5 + 6 = 21
(Cost – Salvage Value) x RUL/SOYD(Cost – Salvage Value) x RUL/SOYD
 11stst
Year (RUL at start = 6)Year (RUL at start = 6)
($100,000 – $40,000) x (6 – 0)/21 = $17,143($100,000 – $40,000) x (6 – 0)/21 = $17,143
 22ndnd
Year (RUL at start = 5)Year (RUL at start = 5)
($100,000 – $40,000) x (6 – 1)/21 = $14,286($100,000 – $40,000) x (6 – 1)/21 = $14,286

SOYD Depreciation ExampleSOYD Depreciation Example
YeaYea
rr
11 (100,000 – 40,000) x (6 – 0)/21 = 17,143(100,000 – 40,000) x (6 – 0)/21 = 17,143
22 (100,000 – 40,000) x (6 – 1)/21 = 14,286(100,000 – 40,000) x (6 – 1)/21 = 14,286
33 (100,000 – 40,000) x (6 – 2)/21 = 11,429(100,000 – 40,000) x (6 – 2)/21 = 11,429
44 (100,000 – 40,000) x (6 – 3)/21 = 8,571(100,000 – 40,000) x (6 – 3)/21 = 8,571
55 (100,000 – 40,000) x (6 – 4)/21 = 5,714(100,000 – 40,000) x (6 – 4)/21 = 5,714
66 (100,000 – 40,000) x (6 – 5)/21 = 2,857(100,000 – 40,000) x (6 – 5)/21 = 2,857

SOYD Depreciation ExampleSOYD Depreciation Example
YeaYea
rr
BeginningBeginning
BasisBasis DepreciationDepreciation
EndingEnding
BasisBasis
11 100,000100,000 17,14317,143 82,85782,857
22 82,85782,857 14,28614,286 68,57168,571
33 68,57168,571 11,42911,429 57,14357,143
44 57,14357,143 8,5718,571 48,57148,571
55 48,57148,571 5,7145,714 42,85742,857
66 42,85742,857 2,8572,857 40,00040,000

Think Break #12Think Break #12
 You buy a piece of equipment for $7000You buy a piece of equipment for $7000
with a useful life of 3 years and expectedwith a useful life of 3 years and expected
salvage value of $1000salvage value of $1000
1) What is the Straight Line depreciation for1) What is the Straight Line depreciation for
the second year?the second year?
2) What is the Sum of the Year’s Digits2) What is the Sum of the Year’s Digits
depreciation for the second year?depreciation for the second year?

Declining balanceDeclining balance
 Depreciation = constant percentage of theDepreciation = constant percentage of the
asset’s current basisasset’s current basis
 Not (cost – salvage value)Not (cost – salvage value)
 Depreciation = Beginning Basis x RDepreciation = Beginning Basis x RDBDB
 RRDBDB = Declining Balance Depreciation Rate= Declining Balance Depreciation Rate
 Declining Balance: $ value of depreciationDeclining Balance: $ value of depreciation
decreases each year, though constant %decreases each year, though constant %
depreciation ratedepreciation rate

Declining BalanceDeclining Balance
 Declining Balance Depreciation Rate RDeclining Balance Depreciation Rate RDBDB
usually a multiple of the Straight Lineusually a multiple of the Straight Line
Depreciation Rate RDepreciation Rate RSLSL = 1/Useful Life= 1/Useful Life
 RRDBDB = 2 x R= 2 x RSLSL, is Double Declining Balance, is Double Declining Balance
or 200% Declining Balanceor 200% Declining Balance
 Also see 1.75/175%, 1.50/150% andAlso see 1.75/175%, 1.50/150% and
1.25/125% declining balance1.25/125% declining balance
 Depreciation for taxes uses decliningDepreciation for taxes uses declining
balancebalance

Double Declining Balance ExampleDouble Declining Balance Example
 Double Declining Balance depreciationDouble Declining Balance depreciation
raterate
 RRSLSL = 1/6 = 16.67%= 1/6 = 16.67%
 RRDBDB = 2 x R= 2 x RSLSL = 2/6 = 2 x 16.67% = 33.3%= 2/6 = 2 x 16.67% = 33.3%
 11stst
Year DDB Depreciation isYear DDB Depreciation is
$100,000 x 1/3 = $33,333$100,000 x 1/3 = $33,333

YeaYea
rr
BeginninBeginnin
gg
BasisBasis
CalculationCalculation DepreciatioDepreciatio
nn
EndinEndin
gg
BasisBasis
11 100,000100,000 100,000 x 33%100,000 x 33% 33,33333,333 66,6666,66
77
22 66,66766,667 66,667 x 33%66,667 x 33% 22,22222,222 44,4444,44
44
33 44,44444,444 44,444 x 33%44,444 x 33% 14,81514,815 29,6329,63
00
44 29,63029,630 29,630 x 33%29,630 x 33% 9,8779,877 19,7519,75

YeaYea
rr
Beginning BasisBeginning Basis DepreciationDepreciation Ending BasisEnding Basis
11 100,000100,000 33,33333,333 66,66766,667
22 66,66766,667 22,22222,222 44,44444,444
33 44,44444,444 14,81514,815 29,63029,630
44 29,63029,630 9,8779,877 19,75319,753
55 19,75319,753 6,5846,584 13,16913,169
66 13,16913,169 4,3904,390 8,7798,779
Problem: Basis can fall below salvage valueProblem: Basis can fall below salvage value

Potential Problems withPotential Problems with
Double Declining BalanceDouble Declining Balance
 Assets withAssets with positivepositive salvage value, basissalvage value, basis
can fall below salvage valuecan fall below salvage value
 Stop depreciation at salvage valueStop depreciation at salvage value
 Assets withAssets with zerozero salvage value, basissalvage value, basis
never reaches zeronever reaches zero
 Switch to straight line after some set timeSwitch to straight line after some set time
 Take remaining value in last yearTake remaining value in last year

(Salvage value = $40,000)(Salvage value = $40,000)
YeaYea
rr
Beginning BasisBeginning Basis DepreciationDepreciation Ending BasisEnding Basis
11 100,000100,000 33,33333,333 66,66766,667
22 66,66766,667 22,22222,222 44,44444,444
33 44,44444,444 4,4444,444 40,00040,000
44 40,00040,000 00 40,00040,000
55 40,00040,000 00 40,00040,000
66 40,00040,000 00 40,00040,000

Compare the ThreeCompare the Three
 Straight Line DepreciationStraight Line Depreciation
 Slowest depreciation; Finishes at the salvageSlowest depreciation; Finishes at the salvage
value without any adjustmentsvalue without any adjustments
 Sum of the Year’s DigitsSum of the Year’s Digits
 Medium rate of depreciation; Finishes at theMedium rate of depreciation; Finishes at the
salvage value without any adjustmentssalvage value without any adjustments
 Declining BalanceDeclining Balance
 Typically fastest (specially DDB); Often has toTypically fastest (specially DDB); Often has to
be adjusted to finish at the salvage valuebe adjusted to finish at the salvage value

0
7,000
14,000
21,000
28,000
35,000
0 1 2 3 4 5 6
Year
Depreciation($)
SL
SOYD
DDB
Depreciation GraphicsDepreciation Graphics

0
20,000
40,000
60,000
80,000
100,000
120,000
0 1 2 3 4 5 6
Year
AssetValue
SL
SOYD
DDB
Asset Value GraphicsAsset Value Graphics

Think Break #13Think Break #13
Machine costs $7000 with a useful life of 3Machine costs $7000 with a useful life of 3
years and salvage value of $1000years and salvage value of $1000
1) What is the double declining balance1) What is the double declining balance
depreciation for the 1depreciation for the 1stst
year?year?
2) What is machine’s ending basis in 12) What is machine’s ending basis in 1stst
year?year?
3) What is the double declining balance3) What is the double declining balance
depreciation for the 2depreciation for the 2ndnd
year?year?
4) What is machine’s ending basis in 24) What is machine’s ending basis in 2ndnd
year?year?

Depreciation and TaxesDepreciation and Taxes
 US tax code has rules and options forUS tax code has rules and options for
depreciating business assets, includingdepreciating business assets, including
those used by farmersthose used by farmers
 MACRS: Modified Accelerated CostMACRS: Modified Accelerated Cost
Recovery SystemRecovery System
 Three methods used: 200% DB, 150%Three methods used: 200% DB, 150%
DB, and Straight LineDB, and Straight Line
 Depends on asset typeDepends on asset type
 Sometime you get to chooseSometime you get to choose

 Determine asset’s basis (called tax basis)Determine asset’s basis (called tax basis)
 Basis adjusted for several reasons, such asBasis adjusted for several reasons, such as
improvements made, damage, etc.improvements made, damage, etc.
 Calculate depreciation as a % of tax basisCalculate depreciation as a % of tax basis
 % taken from a table% taken from a table
 Tax tables assume zero salvage valueTax tables assume zero salvage value
 Deduct depreciation from your taxable incomeDeduct depreciation from your taxable income
(so you pay lower taxes!)(so you pay lower taxes!)
 Tax basis ≠ true value or your book valueTax basis ≠ true value or your book value

 Section 179: Allows taking a large amountSection 179: Allows taking a large amount
of depreciation in year purchase assetof depreciation in year purchase asset
 Way to really reduce income (and so taxes)Way to really reduce income (and so taxes)
 Buy equipment/building and writeBuy equipment/building and write fullfull cost offcost off
as a cost of business in that yearas a cost of business in that year
 The ending basis of asset is zero in first yearThe ending basis of asset is zero in first year
 Many farmers do this in years they makeMany farmers do this in years they make
more money than usualmore money than usual

 Depreciation Recapture: Form 4797Depreciation Recapture: Form 4797
 When sell an asset, if the sales price differs fromWhen sell an asset, if the sales price differs from
the tax basis, file Form 4797the tax basis, file Form 4797
 If sale price > tax basis: claim extra as ordinaryIf sale price > tax basis: claim extra as ordinary
income and pay income taxesincome and pay income taxes
 If sale price < tax basis: claim extra depreciationIf sale price < tax basis: claim extra depreciation
and reduce ordinary income and income taxesand reduce ordinary income and income taxes
 Eventually the government gets its taxes if youEventually the government gets its taxes if you
“over depreciate” an asset via Section 179“over depreciate” an asset via Section 179

 Main Point: Tax depreciation not the same asMain Point: Tax depreciation not the same as
“real” depreciation“real” depreciation
 Section 179 depreciation really throws it offSection 179 depreciation really throws it off
 Businesses & farms: some keep separate recordsBusinesses & farms: some keep separate records
 Tax depreciation and tax basis recordsTax depreciation and tax basis records
 Book value for farm balance sheet for farm’sBook value for farm balance sheet for farm’s
“real” value for loan applications“real” value for loan applications
 Records of asset values for insuranceRecords of asset values for insurance
purposespurposes
 Can create complicated farm recordsCan create complicated farm records

Summary Thus FarSummary Thus Far
 Explained concept of a balance sheetExplained concept of a balance sheet
 Current and Non-current AssetsCurrent and Non-current Assets
 Current and Non-current LiabilitiesCurrent and Non-current Liabilities
 Equity: what balances the sheetEquity: what balances the sheet
 How value Assets: cost or market basisHow value Assets: cost or market basis
 How depreciate assets: straight line, sum ofHow depreciate assets: straight line, sum of
year’s digits, double declining balanceyear’s digits, double declining balance
 Taxes and depreciationTaxes and depreciation
 What do you do with a balanceWhat do you do with a balance
sheet??????sheet??????

What use is a Balance Sheet?What use is a Balance Sheet?
 Can see where assets and liabilities are andCan see where assets and liabilities are and
their relative sizestheir relative sizes
 Can look at changes if have balance sheetsCan look at changes if have balance sheets
from previous years—see if you’re gainingfrom previous years—see if you’re gaining
 Typically focus on ratios to look atTypically focus on ratios to look at LiquidityLiquidity
andand SolvencySolvency of the businessof the business
 Ratios control for differences in businessRatios control for differences in business
sizesize

Current Ratio and LiquidityCurrent Ratio and Liquidity
 Measures ability to meet current financialMeasures ability to meet current financial
obligations as they come due withoutobligations as they come due without
disrupting normal business—ability todisrupting normal business—ability to
generate cash on short-termgenerate cash on short-term
 Current Ratio =Current Ratio =
Current Assets/Current LiabilitiesCurrent Assets/Current Liabilities
 Example: 1.4 or 40%Example: 1.4 or 40%

Current RatioCurrent Ratio
 Too low: cash flow problems, if asset pricesToo low: cash flow problems, if asset prices
change or costs suddenly arise (repairs), canchange or costs suddenly arise (repairs), can
have trouble meeting current liabilitieshave trouble meeting current liabilities
 Don’t want to sell 10 acres to put new roof on barnDon’t want to sell 10 acres to put new roof on barn
 Too high: holding too much cash, current assetsToo high: holding too much cash, current assets
typically have lower return than if put capital intotypically have lower return than if put capital into
other longer term assets or marketother longer term assets or market
 Income lost by keeping cash “under the mattress”Income lost by keeping cash “under the mattress”
 Parable of the talents: buried gold in groundParable of the talents: buried gold in ground

What are typical current ratios?What are typical current ratios?
 IL Farm Business Farm ManagementIL Farm Business Farm Management
Program of 2,166 IL farms in 1996Program of 2,166 IL farms in 1996
 Fairly typical by farm typesFairly typical by farm types
 Farm TypeFarm Type Median Current RatioMedian Current Ratio
HogsHogs 2.032.03
GrainGrain 1.811.81
BeefBeef 1.571.57
DairyDairy 1.331.33

What’s a good Current Ratio?What’s a good Current Ratio?
 Iowa State University ExtensionIowa State University Extension::
 Typically farms with adequate liquidity haveTypically farms with adequate liquidity have
current ratios > 2.0current ratios > 2.0
 Farms with continuous sales (dairy) oftenFarms with continuous sales (dairy) often
have current ratio as low as 1.5have current ratio as low as 1.5
 Beef feeding farms have low current ratiosBeef feeding farms have low current ratios
 Farms with concentrated sales (cash grain)Farms with concentrated sales (cash grain)
need current ratio as high as 3.0 early in yearneed current ratio as high as 3.0 early in year
 Ohio State University ExtensionOhio State University Extension: Measures of: Measures of
Dairy Farm Competitiveness: 1.3 is competitiveDairy Farm Competitiveness: 1.3 is competitive

Working Capital vs CurrentWorking Capital vs Current
RatioRatio
 ““Working Capital” older term used by someWorking Capital” older term used by some
 Working Capital =Working Capital =
Current Assets – Current LiabilitiesCurrent Assets – Current Liabilities
 Measures the margin of safety in dollars (notMeasures the margin of safety in dollars (not
ratio or %) to meet short-term liabilitiesratio or %) to meet short-term liabilities
 Must relate it to size of business, that’s why weMust relate it to size of business, that’s why we
use current ratio!use current ratio!
 $10,000 not much for a 5000 acre farm, but may be$10,000 not much for a 5000 acre farm, but may be
more than enough for a 20 cow dairymore than enough for a 20 cow dairy
 This why most use current ratioThis why most use current ratio

SolvencySolvency
 Measures relative relationships among assets,Measures relative relationships among assets,
liabilities, and equity to assess “health” of firmliabilities, and equity to assess “health” of firm
 Could the farm debt be paid off if foreclosed?Could the farm debt be paid off if foreclosed?
Requires Assets > LiabilitiesRequires Assets > Liabilities
 Measured by three ratiosMeasured by three ratios
 Debt to Asset RatioDebt to Asset Ratio
 Equity to Asset RatioEquity to Asset Ratio
 Debt to Equity RatioDebt to Equity Ratio
 Given any one ratio, you can derive the others,Given any one ratio, you can derive the others,
so each is a different way to look at Solvencyso each is a different way to look at Solvency

Debt to Asset RatioDebt to Asset Ratio
 Debt/Asset = Total Liabilities/Total AssetsDebt/Asset = Total Liabilities/Total Assets
 Proportion (or %) of business assets owedProportion (or %) of business assets owed
to lenders (i.e. % the bank owns)to lenders (i.e. % the bank owns)
 0.70 means you owe 70% of farm assets0.70 means you owe 70% of farm assets
to lenders (bank owns 70%)to lenders (bank owns 70%)
 1.0 means debts = assets1.0 means debts = assets
 Means owner equity is zero, bank owns 100%Means owner equity is zero, bank owns 100%
 > 1.0 means business is insolvent> 1.0 means business is insolvent

Equity to Asset RatioEquity to Asset Ratio
 Equity/Asset = Total Equity/Total AssetsEquity/Asset = Total Equity/Total Assets
 Proportion (or %) of assets ownedProportion (or %) of assets owned
 0.45 means you own 45% of farm0.45 means you own 45% of farm
 1.0 means equity = assets so owner has1.0 means equity = assets so owner has
no liabilities (he/she owns all equity)no liabilities (he/she owns all equity)
 Own 100% of the farmOwn 100% of the farm
 < 0 means business is insolvent—has no< 0 means business is insolvent—has no
or negative equityor negative equity

Debt to Equity RatioDebt to Equity Ratio
 Debt/Equity = Total Liabilities/Owner EquityDebt/Equity = Total Liabilities/Owner Equity
 Proportion of financing provided by lendersProportion of financing provided by lenders
relative to that provided by owner equityrelative to that provided by owner equity
 1.0 means you and your lenders are providing1.0 means you and your lenders are providing
equalequal proportion of financingproportion of financing
 0.75 means for each dollar of equity financing you0.75 means for each dollar of equity financing you
provide, your lender provides $0.75 of financingprovide, your lender provides $0.75 of financing
 1.8 means for each dollar of equity financing you1.8 means for each dollar of equity financing you
provide, your lender provides $1.80 of financingprovide, your lender provides $1.80 of financing
 Very large Debt/Equity ratio implies very smallVery large Debt/Equity ratio implies very small
equity and potential for insolvencyequity and potential for insolvency

Relation between RatiosRelation between Ratios
 Given any of these three financial ratios,Given any of these three financial ratios,
you can derive the othersyou can derive the others
 Basic Accounting Identity must holdBasic Accounting Identity must hold
Assets = Liabilities + EquityAssets = Liabilities + Equity
Assets = Debts + EquityAssets = Debts + Equity
 Notation: A = D + ENotation: A = D + E
 Debt/Asset = D/ADebt/Asset = D/A
 Equity/Asset = E/AEquity/Asset = E/A
 Debt/Equity = D/EDebt/Equity = D/E

 A = D + EA = D + E Divide by A: 1 = D/A + E/ADivide by A: 1 = D/A + E/A
Debt/Asset + Equity/Asset = 1, orDebt/Asset + Equity/Asset = 1, or
Equity/Asset = 1 – Debt/AssetEquity/Asset = 1 – Debt/Asset
Debt/Asset = 1 – Equity/AssetDebt/Asset = 1 – Equity/Asset
 (D/A)/(E/A) = D/E, or(D/A)/(E/A) = D/E, or
Debt/Equity = Debt-to-Asset/Equity-to-AssetDebt/Equity = Debt-to-Asset/Equity-to-Asset
 Rearrange and use D/A and D/E connectionRearrange and use D/A and D/E connection
Debt/Asset = Debt/Equity/(1 + Debt/Equity)Debt/Asset = Debt/Equity/(1 + Debt/Equity)
Equity/Asset = 1/(1 + Debt/Equity)Equity/Asset = 1/(1 + Debt/Equity)
Relation between RatiosRelation between Ratios

Typical Solvency RatiosTypical Solvency Ratios
 IL Farm Business Farm ManagementIL Farm Business Farm Management
Program of 2,166 IL farms in 1996Program of 2,166 IL farms in 1996
 Debt to Asset RatiosDebt to Asset Ratios
 Farm TypeFarm Type upper 25% Median lower 25%upper 25% Median lower 25%
HogsHogs 0.440.44 0.300.30 0.160.16
GrainGrain 0.460.46 0.290.29 0.150.15
BeefBeef 0.520.52 0.310.31 0.170.17
DairyDairy 0.500.50 0.360.36 0.230.23

WI Center for Dairy ProfitabilityWI Center for Dairy Profitability
WI Dairy Balance Sheet for 2000WI Dairy Balance Sheet for 2000
Size (cows)Size (cows) Debt/AssetDebt/Asset Equity/AssetEquity/Asset Debt/EquityDebt/Equity
< 50< 50 22.8%22.8% 77.2%77.2% 29.6%29.6%
51-7551-75 24.3%24.3% 75.7%75.7% 32.1%32.1%
76-10076-100 29.0%29.0% 71.0%71.0% 40.8%40.8%
101-150101-150 31.1%31.1% 68.9%68.9% 45.2%45.2%
151-250151-250 48.8%48.8% 51.2%51.2% 95.2%95.2%
> 250> 250 52.7%52.7% 47.3%47.3% 111.6%111.6%

More InformationMore Information
 Provide a quick list/overview of what sortProvide a quick list/overview of what sort
of information is available onof information is available on farm financefarm finance
 Farm Financial Standards CouncilFarm Financial Standards Council
 University Extension: UW and other statesUniversity Extension: UW and other states
 UW Center for Dairy ProfitabilityUW Center for Dairy Profitability

Farm Financial Standards CouncilFarm Financial Standards Council
 Home page:Home page: http://www.ffsc.org/index.htmlhttp://www.ffsc.org/index.html
 Mission: “To provide education and a national forum toMission: “To provide education and a national forum to
facilitate the development, review, communication andfacilitate the development, review, communication and
promotion of uniformity and integrity in both financialpromotion of uniformity and integrity in both financial
reporting and the analytic techniques useful for effectivereporting and the analytic techniques useful for effective
and realistic measurement of the financial position andand realistic measurement of the financial position and
the financial performance of agricultural producers.”the financial performance of agricultural producers.”
 Financial Guidelines for Agricultural ProducersFinancial Guidelines for Agricultural Producers
http://www.ffsc.org/html/guidelin.htmhttp://www.ffsc.org/html/guidelin.htm
 Recommendations of how to prepare FarmRecommendations of how to prepare Farm
Financial Balance Sheet with several examplesFinancial Balance Sheet with several examples
 TheThe source for this sort of informationsource for this sort of information

UW-ExtensionUW-Extension
 Bruce Jones (AAE, UW-Madison) Focuses onBruce Jones (AAE, UW-Madison) Focuses on
dairy farm management and land valuationdairy farm management and land valuation
 See his home page for most recent papers andSee his home page for most recent papers and
presentations:presentations: http://www.aae.wisc.edu/jones/http://www.aae.wisc.edu/jones/
 Gregg Hadley (Ag Econ, UW-Riverfalls) focusesGregg Hadley (Ag Econ, UW-Riverfalls) focuses
on dairy farm management profitability and financeon dairy farm management profitability and finance
http://www.uwrf.edu/extension/GreggH.htmhttp://www.uwrf.edu/extension/GreggH.htm
 Both work with UW Center for Dairy ProfitabilityBoth work with UW Center for Dairy Profitability

UW Center for Dairy ProfitabilityUW Center for Dairy Profitability
 Homepage:Homepage: http://www.cdp.wisc.edu/http://www.cdp.wisc.edu/
 Focuses mostly (not exclusively) on dairyFocuses mostly (not exclusively) on dairy
 Lots of materials, some financialLots of materials, some financial
 WI dairy data as Farm Balance Sheets forWI dairy data as Farm Balance Sheets for
comparison and benchmarkingcomparison and benchmarking
http://www.cdp.wisc.edu/Financial%20Benchmarks.htmhttp://www.cdp.wisc.edu/Financial%20Benchmarks.htm

Neighboring StatesNeighboring States
 Center for Farm Financial ManagementCenter for Farm Financial Management
http://http://www.cffm.umn.eduwww.cffm.umn.edu//
 Sell/Support FINPACK: “The mostSell/Support FINPACK: “The most
comprehensive computerized farmcomprehensive computerized farm
financial planning and analysis systemfinancial planning and analysis system
available“available“

Neighboring StatesNeighboring States
 Iowa State University: AgDecision MakerIowa State University: AgDecision Maker
http://http://www.extension.iastate.edu/agdm/homepage.htmlwww.extension.iastate.edu/agdm/homepage.html
 University of Illinois: FarmDocUniversity of Illinois: FarmDoc
http://www.farmdoc.uiuc.edu/http://www.farmdoc.uiuc.edu/
 Both have sections on Farm Finance withBoth have sections on Farm Finance with
several publications and decision aidsseveral publications and decision aids

Non-Neighboring StatesNon-Neighboring States
 Oklahoma State UniversityOklahoma State University
 Damona Doye’s web pageDamona Doye’s web page
http://http://agecon.okstate.edu/faculty/profile.asp?idagecon.okstate.edu/faculty/profile.asp?id==ddoyeddoye
 Farm Financial Management ResourcesFarm Financial Management Resources
http://agecon.okstate.edu/faculty/ffmr.asphttp://agecon.okstate.edu/faculty/ffmr.asp
 Farm and Ranch Account BookFarm and Ranch Account Book
http://agecon.okstate.edu/farmbook/http://agecon.okstate.edu/farmbook/

SummarySummary
 Explained balance sheetExplained balance sheet
 assets, liabilities, equityassets, liabilities, equity
 How to value Assets: cost or market basisHow to value Assets: cost or market basis
 How to depreciate Assets: straight line,How to depreciate Assets: straight line,
sum of year’s digits, declining balancesum of year’s digits, declining balance
 Ratios: Current Ratio, Debt:Asset, etc.Ratios: Current Ratio, Debt:Asset, etc.
 How to construct and interpretHow to construct and interpret
 Typical values by farm typeTypical values by farm type
 Where to go for more informationWhere to go for more information

Farm balance-sheet-analysis2765

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